Question #20

Risky debt ownership is economically equivalent to a long position in risk-free bond and a short position in a put option on the assets of the company. (Module 28.4, LOS 28.d) Freeman LLC, is a large investment firm based on the East Coast of the United States. The company manages a range of investment funds with several different objectives but focuses mainly on fixed income investments. Josh Scowen is a credit analyst who has just taken up a position with the firm and is currently familiarizing himself with the various models and techniques used by Freeman. Scowen's first task is to assess the present value of the expected loss (CVA) on a bond issued by Dreamy, Inc., an online retailer of designer fashion products. The company expanded rapidly two years ago, but business conditions have deteriorated recently. Scowen's supervisor is concerned that the company may run into serious trouble soon. Exhibit 1: Dreamy Bond Par $1,000 Annual coupon 8% Time to maturity 2 years Note: the risk-free rate of return is 1.22% (assume a flat yield curve). Freeman also makes extensive use of reduced form and structural models to assess credit risk. Scowen's supervisor has asked him to review the details of the approaches Freeman uses. Scowen recalls using a reduced form model at a previous firm and believes that the following three assumptions are valid: Assumption 1: The company's liabilities can be modelled as a single zero-coupon bond. Assumption 2: The risk-free interest rate is constant. Assumption 3: The probability of default and the recovery rate are not constant. Freeman has recently used a reduced form model to analyze the credit risk of a zero-coupon bond issued by Sleepy, Inc. Exhibit 2 lists some of the details of the simple reduced form model. Exhibit 2: Sleepy Bond, Reduced Form Model Coupon: Zero Face value: $10,000 Time to maturity: 1 year Hazard rate: 0.02 Loss given default: 35% One-year, default-free, zero-coupon bond price ($1 par): 0.95 Credit valuation adjustment: 66.50 Scowen also has a background in option pricing theory from a previous role and is confident that he can put this experience to good use when using a structural model. He believes that structural models value risky debt of a company by deducting the value of a put option on a company's assets from the value of otherwise identical risk-free debt.